(Business 2.0) – Bill Gates was livid. Even for Microsoft executives used to Gates's flame-throwing e-mails, this one made Redmond's top lieutenants cringe. Steve Jobs had just launched Apple's iTunes store last spring, to the adulatory cheers of pop stars and music execs alike. Jobs was hailed as the industry's savior, credited with creating the technology and business model that would make people want to pay for music on the Internet.

So Gates fired off a memo to a handful of senior managers: Why the hell did Microsoft invest hundreds of millions of dollars in a digital media division only to have Steve Jobs race ahead and grab all the glory? Why, Gates demanded, according to some of those familiar with the e-mail, hadn't his people created a service that brought Microsoft all that buzz?

Suddenly, mighty Microsoft was staring at little Apple's taillights, and the pressure was on to create something better than iTunes. Gates's marching orders were blunt: "Let's get to it," recalls Will Poole, a boyish-looking 43-year-old senior vice president who at the time ran the Windows digital media division.

Gates's fury was understandable. The mission to trump iTunes is part of a strategic thrust that's critical to Microsoft's future. The company is angling to become nothing less than the godfather of the living room--the provider of the technology and software that pipes all digital content, from movies to music to TV, to a PC at the core of home entertainment systems everywhere. Killer apps and brilliant code will be key to the effort, but to have any chance at success, the crew from Redmond must do something far more difficult for it than cranking out whiz-bang technology. It has to win the heart of Hollywood.

Cut! you may be thinking right about now. Bill Does Hollywood? We've seen that movie before, and it was a bomb of near Gigli proportions. But things have changed since Microsoft's expensive and largely futile campaign to pry its way into the entertainment biz by buying into cable companies like Comcast and partnering with media bigs like NBC. Hollywood, in many ways, needs Microsoft now. Music was the first to feel the slashing blade of piracy, but soon it will be the movie industry's turn. Broadband is spreading, storage is getting cheaper by the day, and devices linking PCs and TVs are hitting the market. In short, time is running out for Hollywood to tackle a problem it would far rather avoid: how to distribute movies digitally without destroying the rest of its business. It needs technology that can thwart the pirates, and Microsoft has it.

Redmond, meanwhile, needs Hollywood's help too. It's playing catch-up in online music sales--Apple owns 70 percent of that market. Its Xbox game console is a distant second to Sony's PlayStation in the U.S. market, and longtime partners such as Intel are developing entertainment devices that use the open-source Linux operating system rather than Windows. European trustbusters are trying to kill off one of Microsoft's major advantages by forcing it to strip its media player from Windows, or to include a competitor's. Redmond needs Hollywood's content to help beat back those threats, and to make products like Microsoft's Portable Media Center--a combination audio-video player that will hit stores in time for Christmas and that Microsoft hopes will be an iPod-buster--more tempting to consumers. If Microsoft can't win over Hollywood, it risks becoming a sideshow in the digital media age, a fate that would deprive it of billions of dollars in potential profits and relegate it to an unglamorous future of churning out little more than productivity software.

This much common interest would seem to put Microsoft in position to make Hollywood an offer it can't refuse. Here's where the plot thickens, however: The distrust of Microsoft is so deep that Gates & Co. are still struggling to persuade the Hollywood crowd that their intentions are not to take total control of the industry. Kurt Buecheler, a former Microsoft digital media executive and key dealmaker who left Microsoft last September to start his own company, sums it up this way: "When you have zero debt, $60 billion in the bank, and you've decimated technology competitor after technology competitor, you scare the hell out of people. Every time I'd walk into a Hollywood meeting, they'd just look at me like I wanted to screw them."

To understand what's scaring movie executives toward Microsoft's outstretched arms in the first place, meet Brian, a 32-year-old freelance IT worker who lives in a modest ranch home east of San Francisco. There, surrounded by five birds, two Great Danes, a skink, and three boa constrictors, Brian zaps a request to his Internet comrades and seconds later gets a message providing a site login and password. The site offers a copy of Walking Tall available to download--two days before it hits the theaters. Brian has an industrial-strength T-1 broadband connection, which enables him to download a movie in 30 minutes. Then he can easily burn the movie onto a CD so he can watch it on his television. Even people with standard broadband connections can now download a movie in about an hour; in 1999 it took about seven hours. Some experts estimate that by 2007, it will take three minutes. Brian takes a drag on an American Spirit cigarette and shrugs. "It's not really hurting anyone," he says.

With file-swapping services like Kazaa and Morpheus still flourishing and rip-and-burn technologies evolving at lightning speed, the studios know that the masses--not just the computer-obsessed Brians of the world--are just around the corner, poised to download. There are now about 17 million pirated movie files floating around out on the Internet, according to BigChampagne, a research firm that tracks file sharing. That's double what it was a year ago.

To create legitimate and appealing alternatives, the studios need technology partners. Microsoft's pitch is that it can help every step of the way: It makes the software that runs the servers, the compression technology that can turn out DVD-quality movies for downloading, and the digital-rights management software (called DRM) that makes files difficult to hack and gives the distributor control over, say, how a movie can be shared and on how many devices. A studio can create a "master" digital file to use in any form it wants--to sell via the Web, to project on a 60-foot-wide screen, to play on a portable device.

The job of luring the studios is largely in the hands of Amir Majidimehr, who, at 43, runs the Windows digital media division. (He took over for Poole, who was promoted to run the division that includes digital media and all Windows PCs.) A thin, intense engineer, Majidimehr oversees 700 people, mostly programmers working on Microsoft's audio-video technology. How well all this technology works--especially the security features--is crucial to gaining a studio's trust in the first place. Sitting in a Microsoft demonstration room, Majidimehr points to the flat-panel screen where Microsoft shows digital movies while wooing partners. "The studios care about three things," he says. "Piracy, piracy, piracy."

Microsoft by no means has the field to itself. Longtime rival RealNetworks, for example, makes some of the kinds of technology Hollywood needs. But Real's media player has been losing market share, and many studio execs say privately that they're reluctant to commit to a company whose survival is far from guaranteed.

The wild card is Apple. Steve Jobs, who as head of Pixar Animation Studios is easily the most revered tech executive in Hollywood, has said music and movies are so fundamentally different that a portable video player doesn't make sense. Still, though Jobs won't discuss any product plans, Hollywood execs say Apple is working on developing rights management software for video (see "Hollywood Wishes Upon a Star," page 96). But Microsoft is smug about its lead. "The technical teams in the studios will laugh you out of the room if you go in with a system like Apple has today," Majidimehr says.

That leaves Hollywood with a few choices: Ignore the problem, gamble with Real or another struggling player, urge Apple to join the cause, or work with the company that controls the gateway to roughly 90 percent of the world's PCs. Says Scott Dinsdale, the former executive vice president of the Motion Picture Association of America, "This is Microsoft's game to lose."

Sometimes it seems as though Microsoft is trying to do just that.

Microsoft engineer Tim Onders was showing off Windows Media technology one night in February at Los Angeles's Pacific Theater, a high-tech digital cinema laboratory. The audience of about 200 movie and TV engineers was a crucial crowd to win over.

When Onders showed a high-definition clip from The Matrix Revolutions, which was running on a PC and projected onto a 60-foot-wide screen, the onscreen action briefly stuttered. To the untrained eye, the glitch was hardly noticeable. For a demonstration intended to show industry professionals that Microsoft's technology was worthy not just for Internet delivery but also for screening big-budget movies in multiplexes, it was a near disaster. "We can do a better presentation of Windows Media than they do," says one top studio technology chief. "They've got a lot of learning to do."

That echoes a common fear in Hollywood--that Microsoft releases products that are far from ready for prime time. More damning, however, is Microsoft's history with the industry; it's still trying to heal the wounds it created during its early forays into the entertainment world in the mid-'90s. Back then, execs from Redmond would march into Hollywood offices and brazenly suggest that the studios license all their content for distribution on computers--no restrictions, in perpetuity. The reaction? Microsoft's proposals were "hopelessly vague," says Andy Setos, president for engineering at Fox Group. The studios basically threw Microsoft out of town.

Microsoft has dramatically toned down its rhetoric since then. Yet its courting of key executives has sometimes been as clumsy as the Pacific Theater demo. When Microsoft unveiled Windows Media 9 in September 2002, it went Hollywood: Bill Gates appeared onstage at a local theater and showed a video depicting himself, clad in a sailor suit, auditioning for Titanic. Then James Cameron, the movie's director, joined Gates onstage, followed by rapper LL Cool J and other celebs. The audience was crammed with top studio honchos and other big Hollywood players.

After the event, Gates delivered his digital message one-on-one. Yair Landau, a vice chairman of Sony Pictures Entertainment, recalls meeting with Gates in a hotel suite. Landau, 40, was an early advocate of distributing movies via the Internet. He developed a prototype online movie-rental store called MovieFly, and then formed a joint venture with four other studios to roll the service out as Movielink in November 2002. It's still the only Hollywood-initiated service for renting movies on the Web.

Yet here was Gates, giving an entry-level tutorial on why Hollywood shouldn't fear the Internet. "I was a guy who had put my movies online two years earlier and recognized the first time I saw pirated movies on the Internet that there was a business opportunity," Landau says. Such episodes have only furthered the sense in Hollywood that Microsoft remains out of touch with what's going on in the movie business.

A bigger issue is suspicion over how the take from beaming digital content will be divided. Leaning back in a leather chair, Landau gestures to the Spider-Man poster behind his desk and says the Microsoft-Hollywood gulf exists because the economic terms are still undefined. "Microsoft is still not willing to say, 'You spent $150 million making Spider-Man, that's legitimate, and that's disproportionate to any investment we made in software that wraps around it,'" he says. "They haven't said how much of the pie they want."

This kind of talk frustrates Microsoft execs. The company is adamant that it doesn't want an unfair share of studio profits. It charges Hollywood for its technologies but denies any intention of gouging the studios. Redmond expects to really make its money from the increased sales of Microsoft-powered PCs and devices that will result from the spread of easily accessed digital content.

"We know how to make money on one thing, and we want to grow that one thing," Majidimehr says, holding up his right index finger. "We're sitting on a $12 billion [Windows-related] business. If we can get people to have one more PC in the home, one that plays media, we make a few billion dollars more. The way for us to get more content is not to try to reach in their pockets and grab money. That's not the way to build relationships."

To help bridge the Hollywood-Microsoft divide, Redmond has turned to Warren Lieberfarb, the former president of Warner Home Video who's now an L.A.-based consultant. Lieberfarb, 60, is well respected throughout Hollywood because he spearheaded the development of the DVD in the early '90s. The studios fought the DVD and even tried to derail its introduction.

Now, Lieberfarb's cause is broadband--and, he says, it's a far harder sell to studio execs than the DVD was. With the DVD, for instance, Lieberfarb ran focus groups to determine demand and what people would pay. The market for digital entertainment in a broadband world is far less predictable, and many questions remain. Will computers and TV really become inseparable, as Microsoft envisions? When will home networks get to the point where grabbing a movie from your computer is as easy as using a TV? When should the studios even release movies on the Internet? In many ways, this is far trickier than what the music industry faced. Studios release movies in a "window" system--first to theaters, then to rental stores, then to pay-per-view on satellite TV and cable. Internet movie services get access to films at the same time--45 to 60 days after they're released to stores like Blockbuster.

Hollywood's main concern is that moving up online movie distribution will cannibalize its DVD business, which currently brings in half of all studio revenues. Yet if the Internet doesn't get higher preference for new releases, and high-quality pirated movies become easy to download, the studios risk the music industry's fate: having to lure customers to pay services after they've become accustomed to getting content online for free.

"What we're talking about," Lieberfarb says, "is the invention of an entirely new business model." And to really push that process forward, somebody in Hollywood is simply going to have to force the issue by pouring resources into selling movies online--even if that does hurt other parts of its business. Lieberfarb says none of the studios has yet made that kind of total commitment. "Someone at some point has to put serious money on the line," he says.

The looming introduction of a host of iPod-like devices for both music and video may push the studios into making that leap. Microsoft's entry is the Portable Media Center, which can play music, DVD-quality movies, and recorded TV. The company has shown the device off at Academy Awards parties and to execs in studio hallways; it's due out before year-end (see "Coming Attractions," page 93).

For the PMC to succeed, Microsoft needs rich, easy-to-use video content. And it's making some progress. EMI, for example, is exploring ways to make music videos available for the device. And in February, Microsoft inked a deal with Disney (Microsoft's second with a major studio since its agreement with Time Warner last year as part of a litigation settlement) under which Disney will begin putting some of its library into Microsoft's Windows Media format. The content will be customized for the PMC; among other things, that will enable users to download a feature film to a PC in 20 minutes and shoot it onto a PMC in 90 seconds.

The Disney agreement isn't exclusive, but it's still a strong show of support for Microsoft's technology--and it gives Redmond access to an expansive library it believes will help sell the Portable Media Center. Poole, the Microsoft senior VP, calls it the "elimination-of-suspicion announcement." Peter Seymour, Disney's senior vice president for strategic planning, says his company's preference is "always for open standards," but it sees Microsoft as the best way to get its content on many devices securely and quickly--before pirates do it for free.

Microsoft and Disney won't disclose terms of the agreement, but Microsoft says it's been offering roughly 10-year licenses for the package of compression, DRM, and other technologies needed to transmit digital content. That's far longer than typical in the software industry and, Microsoft argues, long enough to provide reassurance that Redmond isn't out to establish itself as a gatekeeper only to turn around and charge industry-crushing tolls. "There's nobody who comes to us and asks us for a long-term agreement who doesn't get it," Poole says.

If Microsoft doesn't have an array of video content ready in time for the all-important holiday shopping season, it might first market the PMC as a luxury iPod. It's also pushing hard on other music fronts: Wal-Mart just launched a music store that works exclusively with Microsoft's format, and it's selling songs for 88 cents apiece, compared with 99 cents at iTunes. But Microsoft is also putting together its own online music store to unveil on the MSN portal later this year--an effort that Gates ordered up in direct response to Apple's iTunes store, some Microsoft executives say.

Microsoft figures it's too early to declare a winner in the digital music wars. Purchased music downloads make up roughly 1 percent of all music sold. And Microsoft hopes its Portable Media Center will attract the many consumers who have yet to buy music online, before they move toward Apple. Microsoft execs are also exploring ideas for an online video store, according to a person familiar with the company's strategy.

Such changes in direction do little to assuage Hollywood's concerns about Microsoft's motives. The message from Majidimehr's group in the Windows media division is that Microsoft strictly wants to be a technology partner. But then the folks over in MSN launch their own music store, turning Microsoft into both partner and competitor. "This is a standard tension we're going to always have," Poole says. "But we have to work hard to create opportunities even if we have competing partners."

Unlike in the late '90s, when the excitement of the bubble led Redmond to create sites like Mungo Park and make lousy investments in broadband companies, Microsoft is clearly not out to be a content company. "We realized what our core strength is," Majidimehr says. In other words, Microsoft now knows full well that its 83 percent margins on software are far fatter than what it could possibly make trying to morph into an entertainment company. Windows licenses and support bring in roughly a third of Microsoft's annual revenue of $34.7 billion, but almost 92 percent of its net income. Research firm Sanford Bernstein estimates that Microsoft's digital media initiatives will produce an additional $6 billion in software revenue during the next seven years.

And even though experts have been forecasting loudly--and incorrectly--for years that we're on the cusp of a new age of widespread digital entertainment, Majidimehr argues that the pieces are finally lining up. In the next couple of years, he figures, everything about audio-video distribution is going to change. "That doesn't mean two years from now consumers will stop buying DVDs," he says. "But the whole machinery will click into place. Then it might take 10 years to transform."

Long before then, it will be clear whether Microsoft and Hollywood are going to manage to work together, unpalatable though the prospect may be for some in Tinsel Town. These days, even many in Hollywood grudgingly admit that the industry will have to do business with Microsoft--the company simply has too many resources and too much influence in the tech world through its dominance of PCs.

Sony, for instance, is a fierce competitor with Microsoft on many fronts, including the living room. Sony is positioning its PlayStation, rather than the PC, to become the computing hub for the home. It's launching Connect, its own music store that will run on yet another format, and plans to open an online video store later this year. It's also showing a prototype of a handheld video player around Hollywood. Yet some Sony online ventures already use Microsoft technology, and Sony seems destined to have a long-term relationship with Redmond for digital distribution.

"Windows is the world we live in," Sony's Landau says. "Pretending otherwise is like me saying I don't want to deal with the fact that it rains. My convertible still has a top that goes up because I have to live in a world in which it rains." Landau even points out a silver lining in Microsoft's preeminence: Though he'd prefer that Microsoft not control digital media standards "in theory," he says there's an obvious need for a ubiquitous format. Otherwise, consumers will face a swamp of choices that ultimately could stall growth and pave the way for the pirates to run riot. And in all things tech, nobody does ubiquitous like Microsoft.

So is the game over? Hardly. For all its power, Microsoft could still blow it. Sony's device could trounce the PMC. Gates & Co. could decide in a year or two to switch strategies yet again. And many of Microsoft's critics in Hollywood remain determined to steer clear of the Redmond cast. Some studio execs, for instance, aren't convinced that Microsoft's motives have changed. They worry about what happens in that 11th year--when the license for Windows Media expires. Would Microsoft try to jack up fees, or make the studios pay extra for new Windows Media versions? One of the issues, says Fox's Setos, is that with Microsoft, "nothing is set in stone. That freaks Hollywood out."

Moreover, Microsoft still needs to make sure all this gear works easily. The bar is high--no one wants to reboot a TV--and products like home networking equipment still have a long way to go. Through the years, Microsoft has put out its share of flops. Remember its cordless phone system? Remember UltimateTV? Remember Bob? Microsoft's worst nightmare is that the Portable Media Center winds up on that list. Imagine the flame-mail Bill Gates would shoot off to his lieutenants then.